Dollar Cost Averaging Can Take Chill Out of Stock Investing

Posted: Mar 24, 2009 12:01 AM
Dollar Cost Averaging Can Take Chill Out of Stock Investing

As severe as stock market losses have been, they have been made worse by our emotions.

I hope a calm look at the numbers will inspire more rational investor behavior -- and better results. At least, let's recognize the role our emotions play so they don't hurt us so much.

I'll focus on the latest annual study by Dalbar, a financial research firm that for 15 years has been analyzing the buy-and-sell decisions of mutual fund investors in the United States. The studies, based on information supplied by the Investment Company Institute, a fund trade group, consistently find that investors on average do much worse than the advertised performance of the funds they own.

"Why? There is one simple reason. When the going gets tough, investors panic," the 2009 study said. Investors tend to sell during market declines and buy when prices rise. In short, they buy high and sell low, a recipe for poor performance.

"The reality is that investors are not rational, and make buy and sell decisions at the worst possible moments," said Louis Harvey, president of Boston-based Dalbar.

For the 20 years ended Dec. 31, 2008, even after last year's losses, the Standard and Poor's 500 stock index chalked up an average gain of 8.35 percent a year compounded, the Dalbar study noted. But the average stock fund investor during that time, switching in and out of funds roughly every three or four years, made just 1.87 percent a year.

That wasn't even enough to keep up with inflation, which averaged 2.89 percent annually during the period.

Repeatedly, the Dalbar study has shown investors sabotage themselves by succumbing to fear and greed. Last year, for example, the S&P 500 lost 37 percent and the average U.S. diversified stock fund lost 39 percent. But the average stock fund investor lost nearly 42 percent, Dalbar found.

In response to those losses, I am seeing many investors go to extremes, abandoning stocks altogether or trying to "get it all back" by piling into risky investments, an ill-advised bet that can lead to even more devastating losses.

For investors who just can't handle the ups and downs of the stock market -- you know who you are now -- it may indeed be better to stick to more conservative fixed-income investments.

True, you won't make much and may have to save more to make up for modest returns. But based on the figures from the Dalbar study, the average stock fund investor would been better off putting his money in bank certificates of deposit the past 20 years.

If you follow this conservative route, though, you must resist the temptation to jump back into the market with both feet when prices go back up.

A more sensible course of action to tame risk and still seek the potentially higher long-term returns of stocks is what Dalbar calls the "time-honored tactic" of dollar-cost averaging, or investing the same amount of money at regular intervals. This strategy does not assure a profit but guarantees you buy more shares when prices are low and fewer when they are high.

"Dollar cost averaging allows investors to slowly make their way back into the markets, and can even make market swings work to their advantage," the Dalbar study said.

For example, the average investor moving in and out of stock funds would have seen $10,000 of total invested principal grow to $13,646 over the 20 years ended Dec. 31, 2008. But somebody faithfully investing $41.67 every month -- also $10,000 total -- would have accumulated $17,037.